WHAT NEXT?

Markets, for the time being, will do the obvious. With Powell set to testify soon before Congress, markets and especially bond investors will be looking to parse his comments. So, what may have changed?

First off, Powell appears to be less hawkish than Yellen. This probably means that the Fed Chair will say something like, the economy will grow at around 3%, we remain concerned about inflation and that employment and wages growth will pick up. But in doing so, if that is what is said, then markets will rally until the impossible is realised cannot happen.

All this stimulus is at the wrong end of the economic cycle. Employment cannot grow much more in a meaningful sense, and that’s not adding more restaurant workers that adding manufacturing jobs, technology jobs etc. The gig economy, for example, is driving wages lower through shared jobs. For example, Uber Eats and the plethora of just in time businesses are helping to keep wages low. In other words, creating value added jobs.

Company intentions are already supportive of a strong equity market because much of the tax cuts will go into share buybacks and increased dividends. Wages, a necessary component for any major growth story, won’t increase significantly, because investments in technology will only drive wages lower.

The classic case now being Bangladesh. Bangladesh long considered a cheap manufacturing hub is finding even its cheap and plentiful labour resource is giving way to technology to make cheaper garments.

For bond investors, they can remain comfortable for a while yet. With steady but slow increases in short term rates, bonds can slowly back up in yield. The cathartic moment for bonds won’t be inflation (although it may play a part), it will be a combination of rotating out of Treasuries, a massive blowout in the deficit, significantly increased issuance and a slowing economy.

Caution is required. Especially if all this happens at a time when the ECB is no longer buying bonds and the Fed has ceased its purchases.

To emphasize the point, Fed policy makers are now debating what to do in the next recession when it eventuates. One point that keeps people like Eric Rosengren (Boston Fed President) awake at night is the widening deficit, limiting the ability to borrow in a downturn.

For the moment, U.S. treasuries look like a great investment – but for how long? The actual yield is high compared to Europe and the carry trade may make the US treasuries even better. Currently, the carry trade is losing money. This month alone the Bloomberg carry trade index is down about 1%.

As investors rotate out of currencies like the yen they no doubt will buy dollars and invest even more of those dollars in treasuries. This makes yen, Euro and Swiss francs vulnerable.

The test ahead for markets generally will be to see how markets behave when the free cash from the major central banks ceases and in fact start to hike rates. A major movement in bond yields would have a negative impact on equity markets generally and this could precipitate a sharp fall as equity markets are rallying on multiples, not on better businesses.

Political intrigue could play its part yet. The Mueller investigation has a few more twists and turns yet and no doubt some bad news will eventually be announced. For the Trump administration, they cannot keep blaming the Obama administration for everything that has gone wrong as the Republicans are painting themselves into a corner.

For the moment global growth is providing a neat stimulus to the U.S. A rapid tightening by central banks elsewhere such as the ECB could imperil that growth and impact the growth story in the U.S. Growth remains delicately poised.

Recap.

Bonds: The ten-year rallied to to close at 2.87%. The 2-year closed at 2.24% and the 30-year closed at 3.155%. The ten-year bund closed at 0.653% and the UK gilt closed at 1.52% and the OAT closed at 0.93%. The U.S. curve flattened to close 2/10 at 62.4bp, 2/30 at 91.3bp and the 10/30, closed at 28.5 bp. The U.S. 5-year closed at 2.62.

Commodities: Gold rose 0.1% and WTI rose 1.2 %. Copper fell 1.09%

Bitcoin is trading around $9605.90.

Aussie Market Today.

Equities in the U.S. finished on a strong note. The Aussie equity market should open with some strength.

Bonds should have a steady rally as the U.S. was stronger on Friday. The AUD is likely to be a little stronger on the day as the U.S. dollar is slightly weaker.